In fiscal year 2003, GIPSA received $4.5 million in appropriations for a broad study of marketing practices in the entire livestock and red meat industries from farmers to retailers, food service firms, and exporters. In June 2004, at the culmination of a competitive bidding process, GIPSA awarded a $4.3 million contract to the RTI International (RTI) to conduct the study.

RTI delivered an interim report in July 2005 describing alternative marketing arrangements and their terms, and reasons that industry participants give for using alternative arrangements.

In February 2007, GIPSA released the final report with the results of the analysis of extent of use, price relationships, and costs and benefits of alternative marketing arrangements.

Fed Cattle and Beef Industries
Executive Summary

As part of the congressionally mandated Livestock and Meat Marketing Study, this volume of the final report presents the results of analyses of the effects of alternative marketing arrangements (AMAs) in the fed cattle and beef industries. This final report focuses on determining the extent of use of AMAs, analyzing price differences and price effects associated with AMAs, measuring the costs and benefits associated with using AMAs, and assessing the broad range of implications of AMAs. The analyses in this volume were conducted using the results of industry interviews, the industry survey data, transactions and profit and loss (P&L) statement data from beef packers, mandatory price reporting (MPR) data, and data from other publicly available sources.

In this report, AMAs refer to all possible alternatives to the cash or spot market. AMAs include arrangements such as forward contracts, marketing agreements, procurement or marketing contracts, packer ownership, custom feeding, and custom slaughter. Cash or spot market transactions refer to transactions that occur immediately, or “on the spot.” These include auction barn sales; video or electronic auction sales; sales through order buyers, dealers, and brokers; and direct trades.

It is important to note that the data collection period, October 2002 through March 2005, was an unusual time for the U.S. beef industry. First, the industry was in transition from the end of the liquidation phase and start of the expansion phase in the cattle cycle. Second, discovery of bovine spongiform encephalopathy (BSE) in Canada in May 2003 closed the U.S. border to Canadian cattle and beef imports. Boxed beef imports from Canada resumed in September 2003, but restricted cattle imports did not begin until July 2005. This immediate restriction on the supply of cattle in the United States led to unprecedented cattle prices and producer profits in October 2003 (fed cattle prices reached levels 30% higher than the previous record high). Third, the discovery of BSE in the United States led to suspended beef exports in late December 2003, causing an immediate and significant decline in beef and cattle prices in early 2004. The tight domestic supply of cattle with resumed beef imports and restricted exports pressured packer margins and resulted in negative packer returns during a portion of the study period. In spite of, or perhaps because of, the turmoil in the markets, fed cattle prices posted record high annual average prices in 2003, which were surpassed in 2004, and then topped again in 2005.

With that backdrop on market conditions, the primary conclusions for this final report, as they relate to the fed cattle and beef industries, are as follows:

• The beef producers and packers interviewed believed that some types of AMAs helped them manage their operations more efficiently, reduced risk, and improved beef quality. Feedlots identified cost savings of $1 to $17 per head from improved capacity utilization, more standardized feeding programs, and reduced financial commitments required to keep the feedlot at capacity. Packers identified cost savings of $0.40 per head in reduced procurement cost. Both agreed that if packers could not own cattle, higher returns would be needed to attract other investors and that beef quality would suffer in an all-commodity market place.
  
• Eighty-five percent of small producers surveyed used only the cash market when selling to packers, compared with 24% for large producers, and pricing methods also differed by size of operation. Large producers used multiple pricing methods, including individually negotiated pricing (74% of producers), public auction (35%), and formula pricing (57%). In comparison, small producers used individually negotiated pricing (32%), public auction (84%), and formula pricing (6%). Four times as many large producers sold cattle on a carcass weight basis with a grid compared with small producers.
  
• Ten percent of large beef packers surveyed reported using only the cash or spot market to purchase cattle, compared with 78% of small beef packers. Large packers relied heavily on direct trade and less on auction barns and dealers or brokers for their cattle procurement compared with small packers. Conversely, small packers used AMAs for approximately half as much on a percentage basis as large packers. Both large and small packers used multiple pricing methods when buying cattle, including individually negotiated prices, formula pricing, public auction, and internal transfer pricing. While nearly all packers bought some cattle on a liveweight basis, 88% of large packers purchased cattle based on carcass weight with grids, while almost no small packers used this type of valuation.
• Neither the producers nor packers surveyed expected the use of AMAs to change dramatically in the next 3 years. In addition, they indicated that their use of AMAs had not changed significantly from 3 years earlier. Auction markets were the predominate marketing method across all producers selling cattle and calves. Based on the survey results, which tend to represent smaller packers, 19% of fed cattle are purchased through auctions. This is a substantially higher percentage than the estimate based on the transactions data obtained from larger packers.
  
• The producers surveyed that used AMAs identified the ability to buy/sell higher quality cattle, improve supply management, and obtain better prices as the leading reasons for using AMAs. In contrast, the producers surveyed that used only cash markets identified independence, flexibility, quick response to changing market conditions, and ability to buy at lower prices and sell at higher prices as primary reasons for using only cash or spot markets.
  
• The packers surveyed that used AMAs said that their top three reasons for using AMAs were to improve week-to-week supply management, secure higher quality cattle, and allow for product branding in retail stores. Much like producers, packers that used only cash markets identified independence, flexibility, quick response to changing market conditions, and securing higher quality cattle as reasons for using only the cash or spot market.
• Transactions data summarized from the 29 largest beef packing plants during the time period of the study included more than 58 million cattle and 590,000 transactions and indicated that the cash or spot market was the predominate purchase method used. Specific estimates of the percentage of cattle purchased through each type of marketing arrangement are as follows:

  – 61.7% cash or spot market
  – 28.8% marketing agreements
  – 4.5% forward contracts
  – 5.0% packer owned, other method, or missing information

  Thus, marketing agreements are the primary AMA used in the fed cattle and beef industries, but other types of AMAs are used extensively by individual firms for specific reasons that benefit their operations.
  
• Transactions data indicate that packing plants in the Cornbelt/Northeast used AMAs less frequently than plants in the High Plains or West regions. High Plains plants procured 61% of cattle by direct trade, 30% through marketing agreements, and a very small percentage through auctions and forward contracts. Cornbelt/Northeast plants bought the majority of their cattle by direct trade, but some were purchased through auctions and marketing agreements. Plants in the West bought a lower percentage by direct trade compared with the other regions and a higher percentage through marketing agreements and auction barns.
• Individually negotiated pricing was the most common method used to determine purchase prices for fed cattle. Specifically, 60% of cattle purchased by plants in the High Plains used individually negotiated pricing, with a similar percentage in the Cornbelt/Northeast and a substantially lower percentage in the West. Formula pricing was used to purchase 34% of the cattle in the High Plains, with a higher percentage in the West and a substantially lower percentage in the Cornbelt/Northeast. The formula was based most often on either U.S. Department of Agriculture (USDA)- reported prices or subscription service prices. Cornbelt/Northeast packers purchased the largest percentage of cattle on a liveweight basis (47%) in comparison with the High Plains (40%) and the West (25%). Packers in the West purchased more than half of their cattle using carcass weight with grid valuation, while packers in the High Plains and Cornbelt/Northeast used this valuation method for 42% and 44% of their purchases, respectively. The remainder werepredominately purchased on a carcass weight basis without a grid.
  
• Regression analysis of the relationship between all fed cattle transactions prices and use of marketing arrangements indicates that, relative to direct trade transactions, prices for fed cattle sold through auction barns tended to be somewhat higher and prices for fed cattle sold through forward contracts tended to be somewhat lower. These results are likely due, in part, to the differences in risk associated with the two methods: auction barn sales are subject to greater price risk, but forward contracts ensure market access and a guaranteed price for cattle producers. However, the results also are influenced by the period of the analysis, during which fed cattle prices were at record highs. The prices for fed cattle sold through marketing agreements and transferred through packer ownership were relatively similar to direct trade. Prices for cattle under packer ownership are internal transfer prices that are typically based on external market prices; thus, implications of the results for packer-owned cattle are less clear.
• Regression analysis of the relationship between cash market (auction barns, dealers and brokers, and direct trade) transactions prices for fed cattle and use of marketing arrangements suggests that if capacity utilization within a plant increases through the use of AMAs, firms pay slightly less per pound for cattle purchased in the cash market. Specifically, a 10 percentage point increase in capacity utilization through AMAs is associated with a 0.4 cent per pound carcass weight decrease in the cash market price. Furthermore, if more cattle are available through AMAs within the following 21 days, cash market prices decrease slightly. Specifically, a 10% reduction in the volume of cash market transactions, assuming that volume is shifted into AMAs, is associated with a 0.11% decrease in the cash market price.
  
• Beef packer plant-level P&L data showed significant economies of scale in beef packing, and costs were decreasing across the entire data range analyzed. When both are operated close to capacity, smaller plants are at an absolute cost disadvantage compared with larger plants. When larger plants operate with smaller volumes, they have higher costs than smaller plants operating close to capacity and, thus, have an incentive to increase throughput. For all plants, large and small, average total cost increases sharply as volumes are reduced. A representative plant operating at 95% of the maximum observed volume is 6% more efficient than a plant operating in the middle of the observed range of volumes and is 14% more efficient than a plant operating at the low end of the observed range.
• Based on an analysis of P&L statements, procurement of cattle through AMAs results in production cost savings to the plants that use them. However, the results differ across firms and plants. Some plants benefited substantially from AMAs and other plants did not appear to capture any benefits. The weighted average industry total production cost savings associated with AMAs was approximately $6.50 per animal. For an industry with an average loss of $2.40 per head during the 30-month sample period, this is a substantial benefit.
  
• Marketing agreements are the most widely used AMAs in the beef industry, and thus restrictions on the use of marketing agreements would have the greatest negative effects on costs of production in the beef packing industry. Forward contracts and packer-owned cattle were used, but to a much lesser extent. Therefore, restrictions on the use of packer ownership and forward contracts for cattle would have lesser effects on costs of production.
  
• While the results differ by plant and firm, simulation analysis indicates that reducing or eliminating AMAs would result in higher average total cost (ATC) for slaughtering and processing beef cattle and, likewise, reduced gross margins and packer profits. The average increase to beef slaughter and processing ATC would be 4.7% with a hypothetical elimination of AMAs and 0.9% with a hypothetical 25% reduction is use of AMAs. Packer profits are estimated to decrease by 6.0% and 1.5% if AMAs were reduced by 100% or 25%, respectively .
• Beef quality has a positive effect on beef demand, the producers and packers interviewed and surveyed believe that AMAs are important for beef quality, and quantitative analyses suggest that AMAs are often associated with higher quality. Regression analysis of MPR data found a small but positive relationship between formula and packer ownership procurement and USDA Quality Grade and found no statistical relationship between cash purchases and USDA Quality Grade. Regression analysis on transactions data found that marketing agreement cattle had a higher percentage Choice and Prime carcasses without increasing the percentage of Yield Grade 4 and 5 carcasses and had only modest declines in Yield Grade 1 and 2 carcasses. Other procurement methods had a greater trade-off between preferred quality grade and preferred yield grade. Furthermore, marketing agreement cattle and packer-owned cattle were associated with relatively higher quality compared with direct trade cattle, as measured by a composite quality index, but the small percentage of cattle sold through auction barns was associated with the highest quality and the highest variability in quality. The small percentage of cattle sold through forward contracts was associated with the lowest quality but also the lowest variability in quality.
• The producers and packers surveyed that use AMAs value them as a method of dealing with production, market access, and price risks. More specifically, feedlots believed that AMAs allow them to secure or sell better quality cattle and calves and improve operational management, efficiency, and capacity utilization. Packers identified AMAs as an important element of branded products and meeting consumer demand by producing a higher quality, more consistent product.
  
• Regression analysis accounting for cattle quality and sales month found that auction market and forward contract prices were more volatile than direct trade, marketing agreement, and packerowned cattle prices. Furthermore, the volatility of prices for direct trade and marketing agreement cattle were relatively similar. Results were generally consistent for fed beef cattle and fed dairy cattle.
  
• Hypothetical reductions in AMAs, as represented by formula arrangements (marketing agreements and forward contracts) and packer ownership, are found to have a negative effect on producer and consumer surplus measures. Beef and cattle supplies and quality decreased and retail and wholesale beef prices increased because of reductions in AMAs. However, feeder and fed cattle prices decreased because of higher slaughter and processing costs resulting from the AMA restrictions. The short-run, long-run, and cumulative present value surplus for producers and consumers associated with reduced AMA volumes are all negative. Over 10 years, a hypothetical 25% restriction in AMA volumes resulted in a decrease in cumulative present value of surplus of
  

  – 2.67% for feeder cattle producers,
  – 1.35% for fed cattle producers,
  – 0.86% for wholesale beef producers (packers), and
  – 0.83% for beef consumers.

  A hypothetical 100% restriction in AMA volumes resulted in a decrease in cumulative present value surplus of
  
  

  – 15.96% for feeder cattle producers,
  – 7.82% for fed cattle producers,
  – 5.24% for wholesale beef producers (packers), and
  – 4.56% for beef consumers.

  Thus, feeder cattle producers lose more surplus relative to the other sectors under either scenario. In addition, the estimated changes would imply a reduction in the competitiveness of beef relative to other meats.
• The cost savings and quality improvements associated with the use of AMAs outweigh the effect of potential oligopsony market power that AMAs may provide packers. In the model simulations, even if the complete elimination of AMAs would eliminate market power that might currently exist, the net effect would be reductions in prices, quantities, and producer and consumer surplus in almost all sectors of the industry because of additional processing costs and reductions in beef quality. Collectively, this suggests that reducing the use of AMAs would result in economic losses for beef consumers and the beef industry. Decisions regarding methodologies, assumptions, and data sources used for the study had to be made in a short period of time. The analyses presented in this volume are based on the best available data, using methodologies developed to address the study requirements under the time constraints of the study. Some analyses were limited based on availability and quality of the transactions and P&L statement data. However, secondary data were used, as available, to supplement primary data to conduct the analyses.

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February 2007